How to regulate digital assets

It would be an understatement to say that the policy discourse surrounding the appropriate regulatory policy for Web3 technologies is polarising. It is heartening that at the Bengaluru meeting of the finance ministers, the G20 has recognised the need for a globally coordinated principle-based approach to address the issue of regulations of private digital assets like crypto.

It is true that digital assets have no underlying value and are mere speculation. But the use-cases for application of digital assets are evolving. The lesson from financial history is that every asset class in its first generation has displayed extreme volatility and thus may be critiqued as being speculative. This is true of the time when joint stock companies first emerged in the 16th century, to the time when Don Valentine (who went on to establish Sequoia Capital) first invented private equity as an investment asset to take exposure to early-stage companies. Markets attach value to “things” and over time, these become assets as institutional and retail capital buys them with the objective of capital appreciation. For example, art has no utility other than aesthetic value derived from a Monet or a Van Gogh. Yet, art has emerged as an important asset class with an estimated $1.7 trillion in value. Gold is another example of a commodity that has no underlying cash flows but is treated globally as an asset. So, what if we don’t regulate digital assets and the intermediary ecosystem that has emerged around them? As the global financial crisis of 2008 reinforced again, we cannot manage risks that bad actors pose in a given market unless we observe, monitor, and supervise that market.

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Like any market, digital asset markets will have good and bad actors. Risks that bad actors (e.g., FTX) pose to consumers don’t just disappear just because regulators ring-fence a particular frontier niche from the formal financial sector. Risks are fungible; in complex systems like financial markets, they merely move to other geographies or to informal economies and manifest in other forms. Ring-fencing digital asset markets from traditional financial markets may result in bad actors operating with impunity in the informal economy or extraterritorially, posing a risk to both domestic financial systems (from a money laundering perspective) and vulnerable segments of our population (from an investor protection standpoint).

So, what is the prescription? First, without creating legal and supervisory frameworks governing the digital assets ecosystem, we will not have the requisite skills and capacity among law enforcement agencies to evaluate, examine, and assess digital records pertaining to digital assets. This aspect was brought into sharp focus in a recent Odisha case where the Vigilance Cell is seeking the assistance of outside experts to evaluate certain records for investigation. Given the lack of regulatory capacity that this incident highlights, it may be argued that even if a blanket ban was imposed, law enforcement will lack the ability to enforce it. As has been documented by the Financial Stability Institute, the peer-to-peer route to execute transactions remains a challenge. But the only way around that is concerted global effort and creating global templates for reporting and record-keeping standards and information sharing between regulators.

Second, digital asset markets exhibit the same characteristics and risks like traditional finance markets. Therefore, the existing regulatory toolkit that regulators have developed over the years may suffice. Maybe, some additional tools to mitigate the potential harm bad actors in this space may visit upon consumers and the financial system in general. However, the Web3 ecosystem is in its nascency, and lawmakers and regulators could avoid prescriptive, micro-managerial mandates and enact principles-based regulations to balance prudence and innovation and let regulatory tools evolve as the market develops. For example, RBI is already piloting CBDC use-cases across retail and wholesale. CBDC has the potential to be meaningful in a cross-border context, with India being the largest inward remittance market. Rather than banning or restricting digital assets, policymakers could probably allow both CBDC and private digital currencies to compete in a regulated environment.

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Licensing and minimum capital requirements will weed out fly-by-night operators or unviable business models and only reputable intermediaries will get licensed to operate digital asset exchange (or other intermediary) business. Likewise, reporting and record keeping mandates under the relevant KYC/ anti-money laundering laws will ensure that digital asset intermediaries are held to the same standard as incumbent traditional financial institutions when it comes to compliance under the money laundering regulations. That may be codified formally by notifying them as reporting Entities under relevant laws.

Third, policymakers should build up a legal syntax precisely defining and classifying classes of digital assets in an umbrella statute. Catch-all expressions like “virtual digital assets” do not capture the nuance that has built up in the digital assets ecosystem over the last decade.

Whether certain stakeholders perceive the development favourably, Web3, digital assets, and blockchain have arrived on the financial markets firmament and bring in potential for benefits as well as risks. India’s G20 presidency offers us a unique opportunity to shape the future of digital assets regulation both in India and globally by creating a facilitative legal and regulatory architecture in concrete terms which can be adopted globally.

(Writers are respectively, member, Rajya Sabha, and fintech sector policy analyst. Views are personal.)